Nausea

While Covid-19, or the coronavirus, is not a stomach bug it certainly seems to be making the markets nauseous.  This week’s daily price movement brought back memories of 2008.  Each day this week the S&P 500 either moved greater than 4% or had a range between its high and low greater than 4%.  Implausibly, at current writing, the index is down just .12% for the week.  Does any of this sound and fury signify anything?  What information can be gleaned from a week of so much price activity?

While stock market volatility has been the most headline grabbing news item, the volatility is running rampant across nearly all asset classes.  The most notable event of the week should be the movement in the 10-year yield on the US Treasury Note.  At the close of business on February 28 the 10-year yield sat at 1.16%, currently it is now trading at .74%--the 10-year rate is now down over 1.18% this year.  The collapsing bond yield is torturing the stock market.  The stock market looks to the bond market for cues on the trajectory of economic growth and the rapidly deteriorating bond yields is signaling anything but growth.   

In last week’s note I closed by mentioning that our momentum strategy would be “de-risking” out of equities.  I mentioned, that given the dramatic collapse in the stock market during the last week of February, we may see a dramatic snap back that would prove our de-risking to be at a short-term inopportune time.  While we did see the stock market snap back early in the week, those gains quickly evaporated and the allocating more to Treasury Bonds proved fortuitous.  High quality bonds have a great purpose to offset losses in stocks during times of panic.  It has proven true throughout history; yet now we sit at historically unprecedented levels in US bond rates, and we seem to have to ask: Can we expect the same assistance from bonds at 0.74% yields as we did at 4.5% yields. 

It’s a fair question, and a question which has dire implications for diversified portfolio construction and risk management.  If bonds are our counterbalance to stock market risk, are they strong enough at depressed yield levels to fight off losses caused by dropping stock prices.  In current times the analogy between stocks and bonds and viruses and antibodies seems appropriate.  If people with weakened immune systems have higher mortality risks to Covid-19, are low yielding bonds similar to weakened immune systems struggling to fight off viral infections from panic stock markets?

The term for a bond’s price sensitivity to interest rate changes is called:  duration.  Duration is expressed in terms of how much a bond’s price will change if the yield changes by a full 1%.  The primary factors which effect a bond’s duration is the time until maturity and the current yield.  Duration increases as time to maturity increases and as the current yield decreases.  For example, a bond with a 20 year maturity and an 8% yield has a duration of roughly 12.75.  A bond with a 20 year maturity and a 0% yield has a duration of roughly 16.3. 

If we own bonds or Exchange Traded Funds which track bond performances as a means of protecting against stock market losses and volatility, then duration is our primary concern for how much help we can expect to get from bonds. 

As current yields begin to approach zero, the answer may seem to become a bit more muddled.  Once upon a time it would have seemed obvious to assume that bonds had a floor at zero, after all what is a negative interest rate.  That time seems oh so quaint now.  Developed nations throughout Europe and Japan have been living in a negative rate environment for a number of years.  We now have their lead as an example.  I by no means view this as an optimal scenario, but just an approaching fact of life.  Zero is not a boundary that we even have to worry about. 

Our bond yields in the U.S. can, and seemingly, most likely will, fall through zero sometime in the not-too-distant future.  How far below zero they could fall is unknowable because we have never been here before.  In thousands of years of civilization, before recent years, interest rates had never been negative.  We are truly in unchartered waters.  If our certainty that below zero was unthinkable was destroyed, can we be certain that negative 10% is unthinkable?  It may seem crazy but who knows.

Bonds at negative yields may continue to provide a buffer for stock market losses, but one factor apart form duration that will diminish their potency will be the income drag.  The iShares 20+ Year Treasury Bond ETF (TLT), which tracks the performance of the long-dated U.S. Treasury Bond (and which we use in our portfolio), currently has a yield of 1.6%.  In a dystopian future where the 20-year yield is negative 10%, the price return on the bond due to interest rate changes would be equally adjusted by the yield.  Precisely, even if the price of the bond increased due to falling rates, the price gain would be offset by whatever the negative yield is. 

As a consequence, substantially negative rates would ultimately cause a destabilizing effect on portfolio management, and an investment managers ability to protect against stock market risks.  Let’s hope that we don’t get there because my head now hurts just considering it.

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